Reaching for Yield: A Simple Model

Miles Kimball poses an interesting question: How can we model "reaching for yield?" He poses this question in response to a claim by John Taylor that the Fed's zero interest-rate policy creates incentives for investors
"to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income." Kimball writes that

The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality.

"Modeled Behavior" blog has a complementary post today, also questioning how "reaching for yield" squares with economic theory. So here is my morning modeling exercise. It is a really simple, partial equilibrium model, but a model nonetheless. I'm not saying it's incredibly realistic, but I wanted to come up with the simplest model of "reaching for yield" I could think of. It has neither investor ignorance, nor irrationality, nor fraudulent schemes.

Safe Assets and Financial Crises

Mark Thoma has shared a link to a new working paper by Gary Gorton and Guillermo Ordoñez called "The Supply and Demand for Safe Assets." The paper brings to mind a once-confidential document written by economists in the Clinton Administration called "Life After Debt" which was recently made public by the team at NPR's Planet Money. The report notes:

In the year 2000, the U.S. Treasury began actively buying back the public debt; we should all appreciate the tremendous achievement this represents for the Nation as a whole... We must realize however, that a sharp reduction in Federal debt and the possible accumulation of a Federal asset raises at least three important issues. First, investors looking for an asset free of credit risk can no longer count on an abundant supply of U.S. Treasury securities, and Treasury securities may no longer provide a reliable benchmark for other interest rates. Second, the Federal Reserve may have to change the mechanisms by which it conducts monetary policy. Third, continued surpluses after the public debt has been paid off will require the Federal. government to acquire assets; either directly or though the Social Security Trust Fund. This raises issues about what kinds of assets might be acquired, and the best way to manage this task.”

Gorton and Ordoñez's paper is relevant to the first of these issues. The Clinton Administration report elaborates on this issue, saying:

US Treasuries are considered free of default risk by investors the world over...The remarkable liquidity of Treasuries is also a result of the full faith and credit of the United States Government.  Holding a liquid asset is valuable because it affords an assurance of convertibility, and thus fast and easy access to capital.  Private investors, the Federal Reserve and many foreign central banks have used Treasuries to fulfill their need for a riskless, performing asset with liquidity second only to currency.

Gorton and Ordoñez note that the share of safe assets in the U.S. economy has remained constant since 1952. However, the composition of these safe assets varies. Safe assets consist of both U.S. Treasuries and privately-produced substitutes, so when the supply of Treasuries declines, the share of private subsitutes rises. What can be a private substitute for Treasuries? Typically, asset-backed securities. Collateral is key.

In Gorton and Ordoñez's model, for simplicity there is just one type of collateral: land. Land can be either "high quality" or "low quality." While the average land quality is known, there is no public information about which land is high quality and which is not. Borrowers can use their land as collateral to finance investment projects, and lenders don't know the land quality unless they pay some cost to find out. This is a type of financial friction: it is inefficient for the economy as a whole if lenders pay a cost to learn about collateral quality, because that cost does not result in any production.

In the model, there are normal times and crisis times. In normal times, the average land quality is high enough that lenders are better off NOT paying to check the quality of the land. The inefficiency from the financial friction is avoided. However, there can be shocks to the average quality of land. Land quality may get low enough that  lenders need to check the land quality before they accept it as collateral, resulting in economic ineffiiency and a financial crisis. This is where Treasuries come in. Government bonds can also be used as collateral, and they don't suffer losses in value like land does. In short:

Since bonds can be effectively used as collateral, a larger fraction of bonds buffers the economy from potential shocks to the expected value of land that may reduce its role as collateral, inducing a lower probability that such shock translates into a financial crisis. This is consistent with the empirical findings of Krishnamurthy and Vissing-Jorgensen (2012a); an increase in Treasury debt decreases the probability of a financial crisis. In our setting this is because bonds can be used as superior substitutes for private collateral – they are independent of shocks to land.

Of course, they are not just advocating for the government to run up a huge debt.The model also includes taxes, and they make the important additional note:

But, if taxes to repay bonds are distortionary, it may be optimal for the government to issue debt in times of crisis, but not in normal times. 

"Land," remember, is a modeling simplification, and really encompasses all types of private collateral. Before the recent financial crisis, there was a surge in the creation of "safe" private assets using "pools" of collateral including loans, bonds, and mortgages. Josh Koval and Erik Stafford explain:

The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create "safe" assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised.

For a time, the AAA-rated top tranches of these manufactured assets were considered really safe, and it was like the "normal times" in the model when lenders trust that on average, collateral quality is good enough that they don't need to pay the extra cost to check on it. But then it became apparent that the average quality was much lower, and these assets became less effective collateral, and the financial crisis began. There are at least some claims that the Clinton surplus kicked off the rise in mortgage-backed securities issuance. (I included two graphs below, made using data from FRED, in case you want to evaluate the claims for yourself.) If you decide to read "The Supply and Demand for Safe Assets," please do also look at Krishnamurthy and Vissing-Jorgensen's empirical counterpart. Or, for something lighter, listen to Planet Money's episode "What If We Paid Off The Debt? The Secret Government Report."

How I Wish this Book Existed

There already exist many books about the financial crisis and Great Recession, but not the one I am most dying to read. Imagine this: a book about the crisis and recession written each chapter written by a different  top female macro or financial economist. Here is my dream chapter line-up.

Chapter 1: Signs of Impending Crisis, Janet Yellen

Chapter 2: International Integration, Contagion, and Domestic Vulnerability, Graciela Kaminsky

Chapter 3: Bank Competition and Systemic Stability, Asli Demirguc-Kunt

Chapter 4: Minding Our Money: Financial Literacy and the Crisis, Olivia Mitchell

Chapter 5: Unconventional Monetary Policy in Exceptional Times, Lucrezia Reichlin

Chapter 6: Quantitative Easing and Portfolio Choice, Annette Vissing-Jorgensen

Chapter 7: Evaluating TARP, Loretta Mester

Chapter 8: Public and Private Spending, Valerie Ramey

Chapter 9: Inventories and the Delayed Recovery, Martha Olney

Chapter 10: Beyond Unemployment Rates: The Great Recession and Material Hardship, Janet Currie

Afterword: Policy and the Power of Ideas, Christina Romer

What do you think? Would other people be excited to read this too? What chapters and authors am I missing?

Quantity Theory in Chinese History

Yesterday Yaohua Li of the Shanghai University of Economics and Finance presented her research on "The Goal of Private Pensions" at the Berkeley Economic History Lunch. After her presentation, I have a new-found tremendous admiration for anyone brave enough to study Chinese economic history. The data challenges are huge-- and so are the potential rewards for anyone diligent and resourceful enough to confront them.

Li is studying the differences in the private pension systems that arose in the United States and China in the 1920s and 30s and trying to understand why the systems developed the way they did. It is not too hard to find data about pension plans in the U.S. in that era, but for China, due to political constraints, no one has been able to collect such data before. Li is doing it totally from scratch. (As someone who has always been able to download my data straight from the Internet, I am blown away!) Her research is too preliminary for me to share results here, but she did bring up an interesting episode in monetary history that I would like to discuss.

In 1934, the United States passed the Silver Purchase Act and as a result began importing significant volumes of silver from abroad, particularly from China. China was on a silver standard, so as its silver flowed abroad, its money supply shrank. Exactly as Anna Schwarz describes, the shrinking money supply caused interest rates to rise. China was relatively unaffected by the Great Depression in 1929-- that depression rampaged the countries shackled by "golden fetters," which transmitted a monetary contraction in the United States and France around the world. But depression hit China in 1934, concurrent with the decline in its silver money supply. Just as the gold standard countries were forced off of gold in the late stages of the Great Depression, China left its silver standard in 1935.

I wanted to know more about what happened next with China's money. Research is substantially limited because of data restrictions, exacerbated by the Pacific War beginning in 1937. There is a 1954 paper by Colin Campbell and Gordon Tullock which includes as its first footnote, "The personal observations of Mr. Tullock have provided the principal data for this study. He was in Tientsin as a Foreign Service Officer from 1948 to 1950." They describe how the Nationalist, Communist, and Japanese governments in China all issued their own currencies and engaged in "monetary warfare," each prohibiting the use of the others' currency beginning around 1938.

In Free China, with the Japanese invasion in 1937, the government increased bank credit as a means of war finance. Campbell and Tullock were up on their quantity theory. From 1937 to 1938, the government was able to expand the money supply faster than prices rose. But in 1938, "people evidently began to realize that prices would rise continuously. As soon as they tried to hold smaller cash balances because they expected inflation, velocity increased sharply...In 1938-44 and in 1946-47 wholesale prices rose more rapidly than the money supply." This is a textbook-example-worthy case of Milton Friedman's distinction between the short run and long run.

In 1988, the Chinese authorities were worried about double-digit inflation and remembered how perfectly Friedman's theories described their own history before 1949. They sought Friedman's advice and apparently followed it, bringing inflation down to acceptable levels.

Real Estate Monetary Standard: the New Wildcat Banking?

Michael Sankowski at Monetary Realism suggests that we may be on a "real estate monetary standard." He writes:

Much like how we can use assets like gold to create a commodity money system, it seems like we operate our current monetary system as a real estate standard.
Banks create money against real estate assets. We use this money in our day-to-day transactions, without much thought about what stands behind this money, but most loans are for residential and commercial real estate.

He makes the comparison to a gold standard, but I suggest another analogy: the Free Banking Era. The Free Banking Era refers to the period from 1837 to 1863. Prior to free banking, opening a bank was a difficult process that involved obtaining a charter from a state legislature, and the Second Bank of the United States required state banks to keep an adequate supply of specie on hand, thereby limiting the amount of notes that they could issue. When the Second Bank closed, states needed to make bank entry easier to fill the void in banking services. New York and Michigan were early adopters of free banking laws, which allowed anyone to operate a bank as long as notes were redeemable on demand and backed by state bonds held at the state auditor's office. Eventually, 18 states adopted free banking laws. I would like to compare the state bond-backed monetary system to what Sankowski calls our real estate monetary standard.

With the passage of the free banking laws, many new banks opened and a plethora of different kinds of banknotes circulated as currency. An expansion of the banking sector in that era has its analogue in the expansion of mortgage lending, including subprime lending, from around 2003-2007, when there was also large growth in non-bank independent mortgage originators. (See Joshua Wojnilower's post on how tax policies created a real estate monetary standard.)

The Free Banking Era is notorious for a large number of bank failures, which often resulted in losses to noteholders. The conventional explanation for the problems of free banking is also a common explanation for the bank failures of recent years: fraud and greed. The evil bankers of those days were called “wildcat bankers." In a well known 1974 paper, Hugh Rockoff explains the link between wildcat banking and free banking laws. Some states allowed banks to issue notes equal to the face value, instead of the market value, of the bonds backing. So wildcat bankers could buy state bonds that had depreciated, deposit them with the state auditor, and issue currency amounting to the face value, rather than the depreciated value, of the bonds. They could then circulate these notes to the public, in exchange for specie and investments worth more than what they paid for the state bonds, forfeit the bonds and run off with the bank’s assets. Sound familiar? Consider Felix Salmon's description of the "enormous mortgage bond scandal."

This is where things get positively evil. The investment banks didn't mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren't going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker. In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors. 

However, as the Economist notes, there has been "a lot of debate over whether blame [for the recent financial crisis] should be assigned to deliberate fraud by financial-industry actors, or whether the whole phenomenon was simply an unfortunate catastrophe based on systemic miscalculations. General opinion settled on the unfortunate-catastrophe thesis." Likewise regarding the free banking era, later authors such as Gerald Dwyer and Arthur Rolnick and Warren Weber argue that most bank closings and noteholder losses were not caused by fraudulent wildcat banks, but rather by capital losses due to drops in state bond prices. There were systemic miscalculations concerning state bonds like there were with mortgage-backed securities. And in fact, they were eerily similar.

State governments at the time were in the business of building roads and canals, running up big debts to do so. It seemed like a great investment, given New York's success with the Erie Canal. States expected to be able to service debt with the revenue proceeds of an expanding tax base; the land boom of the 1830s seemed to promise growing property tax revenues. Plus, the roads and canals that they were borrowing to build were expected to bring in even more revenue. So state bonds were presumably extremely safe assets. It was very similar to the subprime loans made during the housing bubble: even though borrowers didn't have the income they would need to pay their mortgages, they were allowed to borrow because home values were expected to keep rising. But just as AAA-rated subprime-mortgage-backed securities were downgraded to junk status when borrowers started defaulting, the state bonds also sunk in value when many states went into default.

Then as now, leverage mattered. Nine of the ten states with the highest per capita debts defaulted; none of the states with below median per capita debts defaulted. The defaults of course caused financial turmoil and also adversely impacted the real economy. And although the pros and cons of free banking were not well understood until well over a century later, policymakers were fairly quick to impose new regulations. The Free Banking Era came to an end with the passage of the National Bank Acts of 1863 and 1864, which set up a national system of banking with federally issued charters and a uniform national currency backed by Treasury securities. The Comptroller of the Currency was established as a supervisor in 1863; the Federal Housing Finance Agency was established in 2008 to supervise secondary mortgage market components. The parallels are so interesting--this is why I love economic history!

The Value and Values of Finance

When I was an undergraduate at Georgia Tech from 2006 to 2010, I was one of a group of ten Stamps Scholars. The scholarship program was founded by E. Roe Stamps, founding partner of the private equity firm Summit Partners. Since then, the program has expanded to 32 schools and hundreds of scholars. (This is not an economics scholarship-- students have a wide variety of majors.) Now that the program is so large, they hold a Stamps Scholars National Convention every other year. This year's conference will be hosted by the University of Michigan in early April, and the theme is "Solving Big Problems."

Today I received an email sent to all of the Stamps alumni asking for suggested topics for convention sessions. What "Big Problems" should several hundred bright undergraduates think about and work on during the next few years? We were asked to provide a topic, a link to a relevant article, and brief written comments for the students. 

Shortly before receiving this email, I was reading and thinking about Noah Smith's post, "How much value does the finance industry create?" and related posts about the social cost of finance on the Uneasy Money blog. I still don't know exactly where I stand on this topic, but I think it's big and interesting enough to ask this large group of undergrads to think about. They have all benefited from the fortune that Mr. Stamps made in finance, and many are probably considering careers in finance. Here is what I wrote to them. Hopefully it will prompt a good discussion in April and stick in the back of a few young people's minds. If you have other "Big Problems" that you think undergraduates should be thinking about, please leave comments!

Topic: The Value and Values of Finance.

Article: http://www.newyorker.com/reporting/2010/11/29/101129fa_fact_cassidy?currentPage=all

My comments (directed to Stamps Scholars):

As Stamps Scholars, we have all benefited tremendously from finance. Mr. and Mrs. Stamps epitomize the good that can come from finance. They have invested not only in businesses, but also in our education and the future of the community. In the aftermath of the financial crisis, there is increasing sentiment that not all finance is so good.

In the article by John Cassidy, he writes: 

"Since 1980, according to the Bureau of Labor Statistics, the number of people employed in finance, broadly defined, has shot up from roughly five million to more than seven and a half million. During the same period, the profitability of the financial sector has increased greatly relative to other industries. Think of all the profits produced by businesses operating in the U.S. as a cake. Twenty-five years ago, the slice taken by financial firms was about a seventh of the whole. Last year, it was more than a quarter. (In 2006, at the peak of the boom, it was about a third.) In other words, during a period in which American companies have created iPhones, Home Depot, and Lipitor, the best place to work has been in an industry that doesn’t design, build, or sell a single tangible thing...Not surprisingly, Wall Street has become the preferred destination for the bright young people who used to want to start up their own companies, work for NASA, or join the Peace Corps. At Harvard this spring, about a third of the seniors with secure jobs were heading to work in finance. Ben Friedman, a professor of economics at Harvard, recently wrote an article lamenting 'the direction of such a large fraction of our most-skilled, best-educated, and most highly motivated young citizens to the financial sector.'"

You, Stamps Scholars, are without a doubt some of our "most-skilled, best-educated, and most highly motivated young citizens." Whether or not you are considering a career in finance, you will be interacting with the financial sector in one way or another. So how do you decide when finance adds value to society, and when it does not? How do you decide when finance operated with values you can agree with, and when it does not? These are complicated, weighty questions that challenge economists and policymakers alike, and I encourage you to challenge yourselves with them as well.

Japan and the Formation of Inflation Expectations

With the Bank of Japan's adoption of a 2% inflation target making headline news, it seems like a good time to discuss some recent research on the psychology of inflation expecations by Berkeley Professor Ulrike Malmendier, who was recently awarded the 2013 Fischer Black Prize from the American Finance Association. This biennial prize honors the top finance scholar under the age of 40 years old. Malmendier works in the intersection between finance and behavioral economics and is known for her incredible creativity.

Here is the abstract of Malmendier's paper with Steven Nagel titled "Learning from Inflation Experiences":

How do individuals form expectations about future inflation? We propose that past inflation experiences are an important determinant absent from existing models. Individuals overweigh inflation rates experienced during their life-times so far, relative to other historical data on inflation. Differently from adaptive-learning models, experience-based learning implies that young individuals place more weight on recently experienced inflation than older individuals since recent experiences make up a larger part of their life-times so far. Averaged across cohorts, expectations resemble those obtained from constant-gain learning algorithms common in macroeconomics, but the speed of learning differs between cohorts.
Using 54 years of microdata on inflation expectations from the Reuters/Michigan Survey of Consumers, we show that differences in life-time experiences strongly predict differences in subjective inflation expectations. As implied by the model, young individuals place more weight on recently experienced inflation than older individuals. We find substantial disagreement between young and old individuals about future inflation rates in periods of high surprise inflation, such as the 1970s. The experience effect also helps to predict the time-series of forecast errors in the Reuters/Michigan survey and the Survey of Professional Forecasters, as well as the excess returns on nominal long-term bonds.

Malmendier and Nagel's paper over a time period covering several monetary policy regimes, which differ markedly from that of Japan. But a related paper by David Blanchflower and Conall Mac Coille focuses on the UK, which practices inflation targeting.  "The Formation of Inflation Expectations: an Empirical Analysis for the UK" (2009) includes a summary of why inflation expectations matter for monetary policy, and how this is relevant to inflation targeting: 

In the neo-Keynesian model (see, for example, Clarida et al. 2000), sticky prices result in forward looking behaviour; inflation today is a function of expected future inflation as well as the pressure of demand, captured in an output gap term. Thus, expectations are deemed to be an important link in the monetary transmission mechanism. Monetary policy can be more successful when long-term inflation expectations are well anchored. Hence, many studies have focused on the question of how to assess the response of inflation expectations to macroeconomic shocks, and whether this is likely to be lower in inflation targeting regimes. 

Blanchflower and Mac Coille also summarize three paths through which inflation expectations matter:

Wages are set on an infrequent basis, thus wage setters have to form a view on future inflation.  If inflation is expected to be persistently higher in the future, employees may seek higher nominal wages in order to maintain their purchasing power.  This in turn could lead to upward pressure on companies’ output prices, and hence higher consumer prices.  Additionally, if companies expect general inflation to be higher in the future, they may be more inclined to raise prices, believing that they can do so without suffering a drop in demand for their output.  A third path by which inflation expectations could potentially impact inflation is through their influence on consumption and investment decisions.  For a given path of nominal market interest rates, if households and companies expect higher inflation, this implies lower expected real interest rates, making spending more attractive relative to saving. 

In Japan, the third path may be most important. The higher inflation target is intended to lower real interest rates and boost consumption and investment. But there is a fourth reason, not listed by Blanchflower and Mac Coille, of particular relevance to Japan. Foreigners' expectations of future inflation affect the value of the currency. the Japanese Ministry of Finance recently revealed a 222.4 billion yen ($2.5 billion) current account deficit-- a measure of how much imports exceed exports. When people expect Japanese inflation to be higher in the future, the yen gets less valuable now, because it won't be able to buy as much stuff later; the yen weakens. But in this case, weakness is not necessarily bad. A weaker yen means that Japanese people will find it more expensive to import stuff, so they will import less. Likewise, people outside of Japan will find it cheaper to buy Japanese stuff, so Japan will export more. This helps shrink the current account deficit. And depending on the sizes of the income and substitution effects, Japanese consumers may buy more Japanese products.

Under inflation targeting in the UK, even though inflation expectations are reasonably well anchored, and median expectations are around the inflation target, there is substantial heterogeneity across agents in their inflation expectations. Malmendier and Nagel's paper provides a behavioral theory to explain part of this heterogeneity based on agents' heterogeneous past experiences of inflation. Heterogeneous inflation expectations have the potential to affect the workings of all the paths through which inflation expectations matter. We need to understand not only how Japan's inflation target will influence median inflation expectations, but also how it will affect expectations of price setters, wage setters, borrowers, savers, exporters, trade partners, etc. More than likely, these groups differ significantly in their demographics, have had different experiences, and thus form different expectations of inflation. (For reference, the graph below displays Japanese inflation, interest rates, real GDP per capita growth rate, and M2 growth rate. Japan has not seen 2% inflation since 1997.) Extensions of Malmendier's research to other countries and monetary regimes will be very useful in understanding the effects of monetary policy.

Economic Storytelling

Near the end of President Obama's first term, he commented that "When I think about what we've done well and what we haven't done well, the mistake of my first term -- couple of years -- was thinking that this job was just about getting the policy right. And that's important. But the nature of this office is also to tell a story to the American people that gives them a sense of unity and purpose and optimism, especially during tough times." Junot Diaz wrote in the New Yorker that

It has always seemed to me that one of a President’s primary responsibilities is to be a storyteller. We all know the importance of narratives, of stories; they are part of the reasons our brains are so damn big. We need stories, we thrive on them, stories are how we shape our universe. Tolkien could have been talking about the power of stories when he described his One Ring: stories rule us, they find us, they bring us together, they bind us, and, yes, they can pull us apart as well. If a President is to have any success, if his policies are going to gain any kind of traction among the electorate, he first has to tell us a story. 

All year I’ve been waiting for Obama to flex his narrative muscles, to tell the story of his presidency, of his Administration, to tell the story of where our country is going and why we should help deliver it there. A coherent, accessible, compelling story—one that is narrow enough to be held in our minds and hearts and that nevertheless is roomy enough for us, the audience, to weave our own predilections, dreams, fears, experiences into its fabric.

Not only the President, but also members of the Fed, act as storytellers. The word "story" is used 34 times in the January 30-31 Federal Open Market Committee (FOMC) transcripts and a total of 82 times in 2007 FOMC transcripts.

The committee members clearly recognized the importance of providing a narrative to the public. Mishkin said that "We need to tell a story, a good narrative, about [the forecasts]. To be understood, the forecasts need a story behind them.  I strongly believe that we need to write up a good story and that a good narrative can help us obtain public support for our policy actions—which is, again, a critical factor." Similarly, Kohn said that "the story we tell, the narrative, is as important as, if not more important than, the particular numbers that we give out.  It’s really the story that people use to inform their own forecasts of the future, to judge how events are unfolding relative to our expectations, to understand which aspects of the economic environment we’re really paying most attention to, and therefore to help predict."

At times, however, the FOMC had difficulties knowing what story to tell themselves, let alone the public. Here are a few excerpts from the January meeting:


MR. STOCKTON.  At the time of the last FOMC meeting, we were feeling as though the  incoming spending data were coming in pretty darn close to our expectations and were pretty consistent with our story about entering a period of below-trend growth.  As we noted, and President Moskow quizzed us about, the big fly in the ointment with respect to our story was the labor market and its ongoing strength.

MR. STOCKTON As Larry said, even given the overall dimensions of the housing shock, we’ve been
encouraged about our story of stabilization.  But I remember that, as we went into the investment
shock earlier in this decade, we just didn’t have enough imagination about how bad things could
get, and we kept thinking that we were seeing signs of slowing or stabilization, that the new
technology was still great, and that there should be reasons or underlying motivation for investment.

MS. PIANALTO For the most part, the intermeeting data have been favorable for the manufacturing sector.  The industrial production numbers, for example, have been strong, but manufacturing employment remains flat. The usual story that makes sense of these disparate trends is the continuing strength in manufacturing productivity.  But I’d like to mention another element in the picture—others have mentioned it this morning—and that’s the skills mismatches.


MS. PIANALTO ...college placements are up 17 percent this year, the strongest showing since 2001.  The story is that relatively high profits and good business prospects
are driving up demand.

VICE CHAIRMAN GEITHNER We see the same basic story that the Greenbook does in support of continuing expansion going forward.

MR. KROSZNER We have good short-term stories about how the slowdown in energy prices in the
second and third quarters and some other temporary factors with respect to owners’ equivalent
rent could be bringing down inflation.  But when we consider a longer period and try to look at
the systematic data, we don’t see those kinds of relationships.  Are we just in some sort of regime
shift?  Are those correlations not very good because we just haven’t had a lot of variation in the
data over the past ten to twenty years, and so those forces are actually there, but we just find it
very difficult to pull them out econometrically?  For me that is a puzzle, to be able to tell a short-term story with each of these pieces, but when I go to the staff and ask, “Well, what is the
systematic evidence on it?” they say, “Well, it really isn’t there.”  That is a bit disturbing for me
in trying to figure out where things are likely to go.


MR. REIFSCHNEIDER...consider one important communication task, the telling of the central story of the outlook...Distilling an informative message from multiple forecasts is difficult, even if those forecasts provide a considerable amount of detail about the outlook.  In fact, it is an open question as to whether it would always be possible to craft a central narrative that would command the consent of a majority of the Committee, given the diversity of your views...Telling the central story would remain difficult if, after settling on, say, a common path for oil prices, you still disagreed markedly about its economic implications.

MS. YELLEN Given the diversity of views, it’s fair to say that in most meetings, no unified forecast or forecast story even exists, and I don’t see how participants who fundamentally disagree could, if we tried to produce a unified forecast, speak in public about the economy without revealing those differences... One way to expedite the preparation of the narrative is for all of us before the meeting to share our individual forecasts along with a brief written story explaining them.

MR. KOHN ... You could tell a coherent story around the central tendencies.  Sometimes we had to use a little imagination, but it wasn’t really incoherent.  [Laughter]  I think that Chairman Bernanke demonstrated this in his last two testimonies—to take the central tendencies as we submit them and tell a pretty good story that’s helpful to the public.

MR. BARRON I believe it is imperative that any forecast be accompanied by a story to support the
outlook... Numbers without the story would be analogous to asking a doctor to treat a patient by seeing only the skeleton.

Keynes Quotes for the 2007 FOMC Meetings

What J.M. Keynes might have said had he been at the 2007 FOMC meetings:

• It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. --General Theory (1935) Book 4, Chapter 12, Section 2, p. 148
• The decadent international but individualistic capitalism in the hands of which we found ourselves… is not a success. It is not intelligent. It is not beautiful. It is not just. It is not virtuous. And it doesn't deliver the goods. In short we dislike it, and we are beginning to despise it. But when we wonder what to put in its place, we are extremely perplexed. --National self-sufficiency (1933) Section 3, republished in Collected Writings Vol. 11 (1982).
• This is a nightmare, which will pass away with the morning. For the resources of nature and men's devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life ... and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time. --The Great Slump of 1930 (1930), in Essays in Persuasion
• The old saying holds. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed. --Overseas Financial Policy in Stage III (1945), Collected Writings 24:258.

What Keynes might have said today in response to the transcripts:

• There were endless possibilities, not out of reach. --Essays in Bibliography (1933)
• Logic, like lyrical poetry, is no employment for the middle-aged. --Essays in Bibliography (1933)
• Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. --General Theory (1935) Book 4, Chapter 12, Section 5, p. 158
• The disruptive powers of excessive national fecundity may have played a greater part in bursting the bonds of convention than either the power of ideas or the errors of autocracy. --The Economic Consequences of Peace (1919).
• Words ought to be a little wild for they are the assault of thoughts on the unthinking. --New Statesman and Nation (London, July 15, 1933).
• It is ideas, not vested interests, which are dangerous for good or evil. --Concluding Notes, ch. 24, The General Theory of Employment, Interest and Money (1936).
• I do not know which makes a man more conservative—to know nothing but the present, or nothing but the past. --The End of Laissez-Faire, ch. 1 (1926).

FOMC Transcripts: Housing Edition

The transcripts from the 2007 Federal Open Market Committee (FOMC) have just been released. These transcripts are released with a five-year lag. Naturally, economists and pundits are excited to see what people at the Fed did or did not know back then about the state of the economy and impending financial crisis.

The transcript from the January 30-31 meeting includes multiple discussions of the housing sector that suggest awareness of problems, but underestimation of their depth and duration. I've pasted some interesting housing remarks from the transcript at the end of this post. To accompany those, I took a look at what was actually forecast about housing, both at the Fed and by professional forecasters.

Fed forecasts in the Greenbook are also only available with a five-year lag, but the Survey of Professional Forecasters forecasts are available with hardly any lag. In the graph below, the thick navy line is actual housing starts (in millions of units) per quarter. The green line is the Fed's Greenbook forecast made one year earlier for housing starts in that quarter. The dashed line is the same forecast, made by professional forecasters (the median SPF forecast).

You can see that throughout the housing boom, both Fed and professional forecasters consistently underestimated housing starts. Housing starts started to fall in the second quarter of 2006 and have yet to recover to anywhere near their 2006 peak. Look at 2007 in the graph. The blue line is below the red line and far below the green line, which were the forecasts made in 2006 about 2007. I'll update the graph with Greenbook forecasts made in 2007 about 2008 when those are put online.

Here is another graph that shows Greenbook forecasts for housing starts made at multiple horizons. If you draw a vertical line up from a particular date, you will see forecasts made 1 quarter, 1 year, and 7 quarters earlier about housing starts at that date.

Quotes about housing starts in the January 30-31 transcripts:

Mr. Slifman: As I noted earlier, the leveling-off of home sales, the uptrend in mortgage applications, and the improvement in homebuying attitudes suggest that housing demand may be leveling off... cyclical recoveries in sales and starts have generally been fairly coincident historically...Accordingly, we think that the recent stabilization of sales should be accompanied soon by a stabilization of starts.

Mr. Stockton: As Larry said, even given the overall dimensions of the housing shock, we've been encouraged about our story of stabilization.  But I remember that, as we went into the investment shock earlier in this decade, we just didn't have enough imagination about how bad things could get, and we kept thinking that we were seeing signs of slowing or stabilization, that the new technology was still great, and that there should be reasons or underlying motivation for investment.  Perhaps what we've seen recently as stabilization are the beneficial effects of the drop in long-term interest rates that occurred from last summer into the fall and pulled some people forward, but really we may not have fully made the adjustment yet.  The overhang of unsold homes out there is very large, and we could be underestimating the size and duration of that.     

Mr. Stern: The housing sector is subdued, but the District data on sales and starts suggest stabilization, as do the national data.  The data on the inventory of unsold homes perhaps are contradictory to that statement because there are still a lot of unsold properties; at least those data suggest that it will be some time before there is any pickup in housing activity.  In any event, as Bill Dudley mentioned, mortgage delinquencies and foreclosures are rising, albeit starting from a fairly low level, and though that probably won’t have a significant effect on economic performance, it could be a political issue in Minnesota and elsewhere in the District.

Mr. Fisher: I did talk to two of the top five housing CEOs and a third one, a smaller company.  They seem to confirm the sense of the staff in that they feel that the housing situation is bottoming out, but they continue to caution that any reading of the housing industry between Thanksgiving and the Super Bowl is of questionable value.

Coffee Houses and Blogs

Now that I'm blogging regularly again, I am reminded of the coffee houses in late seventeenth and early eighteenth century London, which, much like the blogosphere, revolutionized the way the public consumes and interacts with information. For the small price of a cup of coffee, coffee house patrons could participate in the great social interactions of information exchange. Here's part of a delightful old broadside song from 1667 about the coffee houses. As you read it, think a bit about the blogging world.

You that delight in wit and mirth,
And long to hear such news
As come from all parts of the earth,
Dutch, Danes, and Turks, and Jews,
I'll send you to a rendezvous,
Where it is smoking new;
Go hear it at a coffee-house,
It cannot but be true. 

There's nothing done in all the world,
From monarch to the mouse,
But every day or night 'tis hurled
Into the coffee-house.
What Lily, or what Booker can
By art not bring about,
At coffee-house you'll find a man
Can quickly find it out. 

They know all that is good or hurt,
To bless ye, or to save ye;
There is the college, and the court,
The country, camp, and navy;
So great a university,
I think there ne'er was any,
In which you may a scholar be
For spending of a penny. 

A merchant's prentice there shall show
You all and everything
What hath been done, and is to do,
'Twixt Holland and the King;
What articles of peace will be
He can precisely shew;
What will be good for them or we
He perfectly doth know.

I wrote on my old blog: 

The coffee house revolution and the Internet revolution both changed the was we socially interact with information. In 1674, "The Women's Petition Against Coffee" argued that coffee made men idle and impotent, much as many women today feel about mainly-male online "vices" like online gaming, or the way we all wonder what we're doing spending so much time interacting through a screen. Individual coffee houses came to be associated with particular types of clientele: houses for literary wits, for learned scientists, for lawyers, etc. So people socialized and shared and interacted over the news with other people like themselves-- much like we tend to read the news stories that our own social groups share with us or read blogs by people who think more or less like we think. The fact that we can custom tailor our news exposure to our own interests is a source of both excitement and criticism; it helps us in the necessary task of filtering information, but limits the breadth of our exposure. 

The coffee houses, like the Internet, changed the way finance was conducted. Financial markets are markets in information. So it is important to realize that information exists in a social, political, and cultural context. It is how we interact with it; it is inseparable from its transmission. 

Just for Fun.

My favorite album of 2012 was Some Nights by Fun. I'm not sure how I didn't notice this before, but the song titles and lyrics describe graduate school to an almost spooky degree. Here's a track name and some lyrics for the major phases of grad school.

Start of grad school: We Are Young

So let's set the world on fire, we can shine brighter than the sun.

Middle of first year: It Gets Better

What have we done, oh my god. This is really happening.
You never looked so bored. Can you feel my fingernails? They've never been so short...
Yes, I know it hurts at first but it gets better.
It gets better, it gets better. It gets better, we'll get better.

Second year: One Foot

To my left there's a window.Where did I go?...
And bad ideas, but ideas nonetheless and so
I put one foot in front of the other one. (Oh oh oh!)
I don't need a new love or a new life just a better place to die.

Field exams: All Alright

And it's all alright.
I guess it's all alright.
I got nothing left inside of my chest,
But it's all alright.

Third year: Some Nights

What do I stand for? What do I stand for?
Most nights I don't know.

Fourth Year: Carry On

If you're lost and alone, or you're sinking like a stone
Carry on.

Fifth Year: Why am I the One

I think I kinda like it but I might of had too much.

(If this is your kind of humor, also see Shakira Teaches Economics.) 

Loving the Long Shot

The latest recipient of the 2012 Carolyn Shaw Bell Award is Professor Catherine Eckel of Texas A&M. This award is given annually by the American Economic Association Committee on the Status of Women in the Economics Profession (CSWEP) to recognize an individual who has furthered the status of women in economics. Eckel is an experimental economist who has studied the role of a wide range of social and psychological factors in economic exchange-- attitudes toward risk, gender differences, beauty, trust, corruption, and charitable giving, to name a few.

One of her recent papers is particularly interesting from a macroeconomics and finance perspective: "Loving the Long Shot: Risk Taking with Skewed Lotteries" (2012, with coauthor Philip Grossman). The study addresses a widely noted conundrum, that risk-averse individuals voluntarily play the lottery. The expected payoff of a lottery ticket is less than the price of the ticket. Lotteries are positively skewed, since the vast majority of tickets have low payoff but there is a very small probability of a very large prize. Eckel and Grossman use a laboratory protocol to elicit the skewness preferences of 93 test subjects. They can isolate the effect of positive skewness on subjects' willingness to take risky gambles. If you haven't read an experimental economics paper before, I highly recommend reading Section 3 (pages 7-9) of their paper for an idea of how experimental design works in this field. From the conclusions:

We find that, controlling for risk preferences, individuals are overwhelmingly skewness-seeking in their lottery choices; lotteries with skewed payoffs are more attractive than lotteries with the same expected earnings and risk (variance) but lacking skewness.  Given equal expected earnings and risk, 84.9 percent of our subjects select a lottery with skewness = 1 over a lottery with skewness = 0 and 88.2 percent also prefer a lottery with skewness = 1 or 2 to a lottery with skewness = 0... More importantly, we find that increased skewness in the payoff structure entices a sizeable share of our sample (37.6 percent) to take on greater risk in their choice of lotteries. The change in lottery choices resulting from the skewing of payoffs increases the risk subjects face more than three times as much as it increases their expected payoffs.

The first thing that came to mind when I read this paper was the remarkable lottery loan governemnt fundraising scheme in England in the late 17th and early 18th century, shortly before the South Sea Bubble. An unprecedentedly large lottery was called the "Two Million Adventure." Tickets cost £100 and guaranteed a 6% yield annuity. In addition, tickets won prizes. The maximum prize was £20,000 and every ticket won a prize of at least £10. Prizes were paid in the form of a fixed sum annuity over a period of years, meaning the government held the prize money as a loan until it was paid out to the winners. Investors went crazy for tickets, and all tickets were sold within 9 days. Lottery payoffs were positively skewed. Including the prizes, the great mass of investors earned around a 6.5% yield, but a few lucky winners won much larger amounts, including one grand prize winner. Overall, the average yield was 8%, but the vast majority earned less and a few earned much more. Standard risk preferences suggest that investors would have preferred to buy annuities that simply guaranteed 8% yield, but Eckel's findings explain why investors so loved the lottery tickets. Richard Dale's book "The First Crash: Lessons from the South Sea Bubble" explains how the lottery loans were related to the notorious South Sea Bubble.

Lottery loans were hugely popular in other countries too. The New York Times in 1889 noted that "The new lottery loan has caused a perfect mania among the public of St. Petersburg... At least one hundred times the amount of the 172,000,000 rubles required have already been offered."

Today in the U.S., 42 states and the District of Colombia have lotteries, but positively-skewed payoffs in finance are much more pervasive than explicit lotteries. Most data on stock prices or asset returns has positive or negative skew (unlike normally-distributed data which has zero skew.) For large banks, an implicit or explicit bailout guarantee can put a lower bound on the payoff of risky investments without imposing an upper bound, a widely recognized source of moral hazard which has frequently been blamed for the financial crisis. Prevalent and strong skewness-seeking preferences could make the moral hazard problem stronger than standard models would predict. 

I am glad that CSWEP recognized Eckel's contributions to women in economics and hope the wider economic community will spend some time reviewing and discussing her very interesting research.

Monetary Policy and Inequality

Technical statistical details don't usually make headlines, but in Britain they have, and for good reason. The Office for National Statistics (ONS) announced that they would not change the way they calculate the Retail Prices Index (RPI), the country's oldest measure of inflation. A change to the RPI was expected because the formula used to calculate it is widely recognized as flawed.

The Consumer Price Index (CPI) is the price index used for inflation targeting and other macroeconomic purposes. It was introduced in the 1990s and is calculated in a similar fashion across countries. Compared to the CPI, the RPI tends to be higher by around 1.3 percentage points. Why does this upward bias matter? The RPI is used as the price index for inflation-linked government bonds and for many company pension payments. If the ONS had changed the formula, pensioners and holders of these bonds would have received lower future payments. Pensioners tend to be older, so some groups representing older people lobbied against the change. Of course, other people would have benefited from the change, namely some companies and taxpayers who are financing these pensions and bonds.

This actually brings up a broader point about monetary policy. Protection against inflation varies significantly across the population, so monetary policy is redistributive. People don't all experience inflation in the same way. It depends on the share of their income that comes from labor income versus financial income and also on the proportion of their assets indexed to inflation. Moreover, some people's wages are indexed to inflation or at least respond quickly to inflation, while other wages are "stickier." And as illustrated by the RPI situation, even inflation-linked assets may not perfectly track inflation dynamics. Age, income, employment status, and asset holdings all play a role in determining how monetary policy affects a person.

My adviser Yuriy Gorodnichenko and several coauthors have a recent paper called "Innocent Bystanders? Monetary Policy and Inequality in the U.S." They note that there are several theoretical channels through which monetary policy can affect income inequality. For example, if low-income households tend to hold relatively more currency than high-income households, then increased inflation would create a transfer from low-income households toward high-income households. Some of the channels predict that monetary policy will increase inequality, while other channels predict that monetary policy will decrease inequality. So a priori, the effect of monetary policy on inequality is ambiguous. Through careful empirical work, they are able to determine which channels are strongest. They find that monetary policy accounts for about 10-20% of the increase in inequality since the 1980s. In particular, contractionary monetary policy shocks "have effects on labor earnings which vary systematically across the income distribution: labor income rises at the upper end of the distribution and falls at the lower end." (Their empirical results apply to the United States, not to Britain, where the relative strength of the various channels could be different.)  Considering the redistributive impacts of monetary policy, not just its overall impact on GDP, is an important challenge.

Things I Think of When I Can't Sleep

Commodity Money

Fiat Money

                

                                        

                       Commodity Bunny

Fiat Bunny

Fiscal Cliff, Platinum Coin, and Reign of the Dollar

Almost two years ago, Barry Eichengreen published an op-ed called "Why the Dollar's Reign is Near and End." The article condenses many of the arguments of his book Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. He writes (my emphasis added):

Finally, there is the danger that the dollar's safe-haven status will be lost. Foreign investors—private and official alike—hold dollars not simply because they are liquid but because they are secure. The U.S. government has a history of honoring its obligations, and it has always had the fiscal capacity to do so. 

But now, mainly as a result of the financial crisis, federal debt is approaching 75% of U.S. gross domestic product. Trillion-dollar deficits stretch as far as the eye can see. And as the burden of debt service grows heavier, questions will be asked about whether the U.S. intends to maintain the value of its debts or might resort to inflating them away. Foreign investors will be reluctant to put all their eggs in the dollar basket. 

The recent fiscal cliff fiasco and the current debt ceiling and platinum coin issues make me wonder if Eichengreen's prophesy is coming closer to fruition. So I started by looking at the exchange rate of the dollar against some other currencies from 2011 onwards. I chose the Canadian Dollar (blue line) and the Australian Dollar (green line), since the IMF recently declared them official reserve currencies, and since they are not as contaminated by recent events as the Euro and the yen. Look at the very far right of the graph, and you see both series drop down. That means that the dollar lost value relative to those currencies. One U.S. dollar can buy less Canadian or Australian dollars than before. In other words, the U.S. dollar got weaker.

Let's zoom in and have some fun with Google. I looked at Google trends data for the term "fiscal cliff." Google Trends gives you a measure of search volume for a particular term over time. The thick green line is the search volume for "fiscal cliff" and the dashed line marks its maximum. Notice how, when concern about the fiscal cliff got really high, the dollar got weaker. After President Obama signed the bill on January 2, the dollar continued to weaken, though not as drastically (the flatter downward slope). This is just a "playing around" finding and obviously not econometrically rigorous, but lends some anecdotal evidence to Eichengreen's predictions. Severe fiscal problems are chipping away at the dollar's "exorbitant privilege." If you want to have some fun, try out making a similar graph with the search term "platinum coin."

Kristoffer Nimark on "Man-bites-dog business cycles"

I am excited to attend the UC San Diego macroeconomics seminar tomorrow at 3:30. Kristoffer Nimark will be presenting a paper called "Man-Bites-Dog Business Cycles." From the abstract:

The newsworthiness of an event is partly determined by how unusual it is and
this paper investigates the business cycle implications of this fact. We present a tractable
model that features an information structure in which some types of signals are more likely
to be observed after unusual events. Counterintuitively, more signals may then increase
uncertainty. When embedded in a simple business cycle model, the proposed information
structure can help us understand why we observe (i) large changes in macro economic
aggregate variables without a correspondingly large change in underlying fundamentals (ii)
persistent periods of high macroeconomic volatility and (iii) a positive correlation between
absolute changes in macro variables and the cross-sectional dispersion of expectations as
measured by survey data.

There is still a lot to learn about how information and uncertainty affect the macroeconomy. There are so many news headlines like ``Prolonged Uncertainty Impacting Small Businesses’ Ability to Create Jobs" and "Weak job picture, uncertainty drove QE3," but very little understanding of how uncertainty is generated and propagated and how it interacts with the business cycle. One interesting recent paper on this topic is Nicholas Bloom and Scott Baker's paper, "Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments." I am doing some research in this area myself.

Copernicus and the Platinum Coin

Fun fact: Copernicus was a monetary theorist. Yes, the astronomer extraordinaire who worked out a theory of the revolution of celestial spheres also turned his attention back down to earth to consider currency reforms in his native Poland. At the time (early 16th Century), Poland had three different types of currency. All were made of precious metals, but were subject to frequent debasement, since the state could alter their value by decree.

Copernicus explained that Gresham's law was at work. When multiple coins are in circulation, those with cheaper metallic content relative to their value will be used for payment, while those with more expensive metallic content will be melted down for their metal and disappear from circulation. In short, "bad money drives out good." Copernicus also was an early developer of the quantity theory of money, that prices vary directly with the size of the money supply. He thought that the government needed to stop minting so many coins if they wanted to solve the inflation problem. He published his monetary ideas in Monetae cudendae ratio in 1526.

Copernicus focused on coins whose value derived from their metallic content. Today, of course, our paper currency does not get its value based on the value of the paper itself; it is not commodity currency, but fiat currency. What about the trillion dollar platinum coin we keep hearing about in the debt ceiling discussions? It would not get its value from its metallic content either. The government does not actually have a trillion dollars worth of the commodity platinum to mint into a coin. The coin would just use a small amount of platinum, and have its value by fiat. It is just as if the President were allowed to print a trillion dollars of paper money, which he's not. (That's why the platinum coin scenario is called a loophole.)

Something Economists Can Agree On

It turns out economists can agree on something: why they disagree. Chicago Booth conducts an "Economic Experts Panel" that asks top economists from top departments their opinions on economic policy questions. Along with their answers, the economists say how confident they are of their answers. Weighted by confidence, 98% of economists either agreed or strongly agreed with the following statement:

Question C: Although they do not always agree about the precise likely effects of different tax policies, another reason why economists often give disparate advice on tax policy is because they hold differing views about choices between raising average prosperity and redistributing income.

None of the economists disagreed with the statement, and just a handful did not answer or had no opinion. Richard Thaler agreed, and wrote in the comment, "duh."

This just serves as a reminder, in the ongoing tax debates, of what we are actually debating. Not "taxes are good" versus "taxes are evil," but the relative benefits of raising average prosperity versus redistributing income. Raising average prosperity and redistributing income are not necessarily opposed, but different policies do a different balance of the two.

What's the Basel Buzz?

The financial press is abuzz this morning with news about a decision to ease the Basel rules regulating international banking. What does this mean? Are we entering a new period of financial deregulation so soon after the financial crisis?

In short, no. The Basel regulation at issue is the Liquidity Coverage Ratio (LCR), which will require banks to hold an adequate buffer of highly liquid assets--basically things like cash and treasuries-- to help them meet unexpected short term needs. In a period of financial distress, a lot of people might want to withdraw their money from the banks, but if the bank has too much money tied up in illiquid assets, then it won't be able to meet this demand for liquidity, and the central bank will have to step in and rescue the bank by acting as lender of last resort.

Banks don't earn much money on the liquid assets they hold, so they would gladly hold less of them and let the central bank come to the rescue when needed. But the central bank and the taxpayers want to keep expensive rescue efforts to a minimum, via regulations that require banks to hold adequate liquidity. Basel tries to harmonize regulations across countries so that a bank can't just move its headquarters to the country with the least strict regulations.

The LCR was set to be fully implemented by 2015. The decision this weekend was to implement it gradually, starting in 2015, but not fully until 2019. The other part of the decision was to count a wider variety of assets as highly liquid. So the news is not that an existing requirement is being loosened, but that a future requirement is being pushed further into the future and slightly loosened. Banks in 2015 and in 2019 will still be more regulated than they are today. Most of the press coverage notes how European bank stocks have surged at the news. Stock prices reflect expected future profits. Since banks will be able to hold less liquid assets from 2015 to 2018 than they would have without this decision, their profits will be higher in those years, so their stock price is higher now. There is also a greater chance that government bailouts may be needed.

The financial crisis inspired a lot of new proposed regulations. Many of them are so controversial that their implementation keeps being delayed. I see regulations set to be implemented several years from now as still subject to revision, and do not count revisions as deregulation.

Central Bank Independence

I remember a worksheet my teacher gave us in early elementary school called "Smiley Words and Frowny Words." We had a vocabulary list and were supposed to draw the appropriate smiley or frowny face to match the positive or negative connotation of the word. Most of the words-- freedom, fortune, distress-- had definitely positive or definitely negative connotation. But I remember being puzzled when I started trying to classify all the other words I could think of, and most seemed neither smiley nor frowny. Some words have emotions already attached, but the vast majority have a neutral connotation, and gain meaning only from context. This was astounding to me as a seven year old, and may explain some part of why I became a scientist and a writer, and my approach to both of those roles.

In my last post I wrote about a threat to central bank independence in Japan. At least, that is how it was phrased in all of the news articles that covered the story. None of the articles explained what central bank independence actually means, or why it matters. But at least to American ears, independence is a happy word. For anyone who went through the American school system, the word brings about a mental image along the lines of Thomas Jefferson waving the Star Spangled Banner while an eagle soars overhead. Oh, and plenty of fireworks. Yes, independence sounds good, and a threat to independence sounds like something we should be very angry about.

But when it comes to central banks, the concept of independence should, a priori, be neutral. Economists don't actually have conclusive evidence about whether or not central bank independence is beneficial-- probably in some cases it is, and in some cases it isn't, and it all depends on how you want to define independence and beneficial. I listened to some top economists discuss the matter for four hours on Friday, at two sessions of the American Economics Association conference, and reach no strong consensus. After one of the sessions, Fox almost instantly published an article crying  that "Central banks have sacrificed some of their cherished political independence."

The article makes no indication that this cherished political independence is of questionable value. Nobel Prize winner Joseph Stiglitz has remarked that
"...one of the central principles advocated by Western central bankers- the desirability of central bank independence-was questionable at best…In the crisis, countries with less independent central banks-China, India, and Brazil-did far, far better than countries with more independent central banks, Europe and the United States. There is no such thing as truly independent institutions. All public institutions are accountable, and the only question is to whom."
The issue of central bank independence is very relevant right now, not just for Japan but also for the United States, India, and much of Europe. I think, because of the connotation of the word independence, that people will just assume that more independence is better. And it really does matter what the public thinks, since this is a highly political issue. What we really need is central bank effectiveness, and in some cases that may come from more cooperation with other parts of government. In Japan, where inflation is too low, the new Prime Minister Shinzo Abe is pressuring the Bank of Japan to share a 2 percent inflation target with the government. The Bank of Japan will vote on the new target on January 21-22. A united front by the Bank and the government might be just the ticket to making the inflation target credible and reviving the long-suffering Japanese economy. 

I may write more about central bank independence in a future post, but the point I really want to make is that the economy depends on policies and politics, which depend on public perceptions. And as much as economists would like to believe that people are all perfectly rational and attentive decision-makers, really almost all of us make a lot of decisions really quickly, based on gut responses emotional reactions. We skim an article and make a smiley face or a frowny face. That's not a bad thing; gut responses and emotional responses make life worth living. It is just something economists and readers of economics need to be aware of, and part of the reason why it is so important for economists to learn to communicate better.

Communication about economics the topic of a panel discussion I attended yesterday called "Models or Muddles: How the Press Covers Economics and the Economy." Some of the biggest names in economic journalism were there-- Tyler Cowen, Adam Davidson, Kelly Evans, Chrystia Freeland, and David Wessel. Adam Davidson, from NPR's Planet Money, talked about the craft of making an emotionally compelling narrative in economic journalism while remaining intellectually upright. He mentioned how a story about the housing crisis, for example, should have a human element but shouldn't feature the "most sad-sack" person you can find just to make the banks seem evil. I couldn't agree more.